An Overview of Phantom Income in a Professional Services Firm

Owners of professional service firms face a variety of tax issues. One of the most impactful is phantom income: money that has been allocated to an individual but has yet to be distributed. 

Partners and executives, particularly those tasked with managing distributions, must understand the concept of phantom income. Identifying the tax implications of the decisions your firm makes around distributions enables you to proactively plan for phantom income and ensure partners don’t face an unpleasant surprise come tax filing season. 

In this overview, we explore phantom income in more detail, defining what phantom income is and what typically causes it in a professional services firm. We’ll also explore how business owners, CFOs, and controllers can best plan for phantom income and explore the opportunities available through phantom deductions. 

What is Phantom Income?

The majority of professional services firms are structured as partnerships: a form of flow-through entity that distributes profits to partners on a routine basis. Phantom income occurs when an owner has more income allocated to them than they received during the year. Since partners are required to pay taxes on the income allocated to them, not the money they actually received, failing to manage phantom income appropriately can cause significant tax issues for partners. 

Let’s consider a simple example. Two partners are in a 50/50 partnership and make $100,000 for the year, or $50,000 each. Instead of taking distributions of $50,000 each, the two partners decide to each take a $30,000 distribution, leaving the remaining $40,000 in the business as operating capital. 

In this example, each partner walks away at the end of the year with $30,000 in cash but has to pay tax on $50,000 of income allocated to them. The $20,000 difference is phantom income. 

The example above is simplistic. In any well-established professional service firm, these calculations are far more complex. Compensation costs are likely the firm’s most significant expense. Plus, partners are likely very attuned to the profits allocated to them versus the amount they are paid, making it vital business offices get this right. 

Typical Causes of Phantom Income

Phantom income can be driven by a variety of factors. A common scenario is the situation outlined above, where the partners of the firm choose to leave some portion of the income allocated to them in the business, instead of distributing it to themselves. 

Another common cause is using cash from operations to pay down the principal of a loan. Perhaps your firm took out a loan to purchase an office or to buy new equipment and has now decided to pay down the principal of the loan. Funds used to pay down the principal are considered income since they are not operating expenses. 

Here’s an example. A professional services firm earns $1.2 million during the year. At the annual distribution meeting, the partners decide to distribute $1 million among themselves and use the remaining $200,000 to pay down the business’s debts. Collectively, the partners are liable for taxes on the $1.2 million of income allocated to them, even though they only distributed $1 million of it to themselves.  

Client advances are another common cause of phantom income. Many professional services firms front significant costs on behalf of their clients, from indirect costs such as software to hard costs like filing fees. The client will be billed for this at a later date, but in the interim, the firm’s own capital is tied up in these costs, which typically cannot be deducted as operating expenses. Managing these costs consistently from year to year is key to minimizing phantom income issues. 

Another common cause of phantom income when preparing tax returns are deductions incurred by the firm in typical operations that are disallowed by the IRS. Common examples of these types of expenses are only being allowed a 50% deduction for business meals with a client, prospect or employee. Another example may be the fact that no tax deductions are allowed for entertainment expenses like tickets to an event, parking paid for on behalf of employees, and premiums paid by a firm on life insurance for their partners. All of these are typical operating expenses of a firm that are disallowed for tax purposes, resulting in additional income being allocated to partners.

Phantom Deductions

Phantom income is relatively common in professional services firms, but the inverse of phantom income can also occur: phantom deductions. These are costs that the IRS allows businesses to be forgiven of, essentially allowing businesses to accelerate deductions without recognizing income, or costs paid for by receiving an influx of capital for the firm without recognizing any income. This can be accomplished by raising capital from equity partner buy-ins or taking out a line or credit for the firm.

The most notable example of this in recent years is the Paycheck Protection Program (PPP) loans. Many companies took on these loans. If they met certain provisions, these loans were forgiven, tax-exempt. In essence, this allowed firms to receive an injection of capital, use it for their operations, and never recognize the tax consequences of it. 

Phantom deductions can also occur when a business seeks equity funding. Consider the example of a startup business that receives $1 million in seed funding from an investor. The startup uses this money to fund its operations. The majority of these expenses are operational expenses, and therefore tax-deductible. This contributes to potential tax losses that can be used to partially offset taxable income in current and future years. 

Tax Planning for Phantom Income

With the appropriate tax planning strategies, professional service firms can take a considered approach to managing phantom income that ensures partners are prepared for any tax issues. 

Many professional service firms follow a cash or modified cash accounting basis, rather than an accrual basis. This allows them to align revenue and expenses with the cash flows in and out of their business and partially mitigate phantom income issues. 

Another critical element of tax planning for phantom income is ensuring that everyone understands how income is allocated under the operating agreement of the professional services firm. Every firm takes a unique approach, whether that’s allocating income on a unit basis or based on the revenue each partner generates during the year, and understanding this is key to accurately projecting the tax consequences of phantom income.  

It’s also crucial to understand how the business operates and identify the timing of distributions. It’s the role of the firm’s business office, in partnership with their tax advisors, to determine the potential tax consequences of distributions and to help partners plan for these. 

If the business has operating capital reserves, it might use these funds to cover the delta between the income allocated to partners and the cash available to pay them, ensuring partners have the liquidity to meet their tax obligations.

Alternatively, business offices might adopt a cash withholding policy to ensure that partners are able to meet the tax obligations associated with their distributions. Many professional service firms hold back 25% of the distributions a partner is entitled to in a cash withholding account and distribute these as a designated tax distribution every quarter.   

Smith + Howard: Experienced Tax Advisors for Professional Services Firms

Without the right approach, phantom income can quickly turn into a major headache for partners of professional service firms. Larger, more well-established firms may be able to smooth out many phantom income issues with retained funds, but for smaller, growing firms, phantom income may present more of a challenge. 

At Smith + Howard, our tax professionals take a consultative approach to helping professional service firms manage and communicate phantom income issues. Our team works closely with business offices to help CFOs, COOs, and Controllers understand phantom income issues and develop tax memorandums that help partners understand the tax implications of the distributions they receive from the firm. 

To learn more about Smith + Howard’s tax planning services for professional services firms, contact an advisor today.